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How Safe Is Costco and Its Dividend?

By Lawrence Rothman, CFA - Jun 11, 2020 at 12:30PM

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Costco has traditionally offered steadily improving results and dividends. Can the warehouse club operator continue to do so?

Like many other stocks, Costco Wholesale's (COST 1.33%) share price has been volatile since late February. The stock fell from around $325 to $280 in a month before partially recovering to $305.

Most recently, the coronavirus and governments issuing stay-at-home orders caused the market's swoon. However, the retail sector has been under pressure over the last couple of years due to consumers shifting more of their shopping online.

Is this a major concern for Costco and should you worry about the dividend?

An aisle in a warehouse with stocked shelves.

Image source: Getty images.

How serious are online threats?

Companies like Amazon.com (AMZN 1.24%) offer attractive prices, and its Prime service enables most users in the U.S. to receive items in two days (certain cities receive same-day delivery).

Amazon and others are not standing still, either. They are offering an ever-widening array of merchandise at increasingly faster delivery times. While this has the potential to hurt Costco's business, the warehouse company's business model is different and more resilient than that of most retailers. It charges a membership fee, which allows people to shop at its clubs.

This gives them access to a wide range of high-quality merchandise at low prices. Along with a generous return policy, this is a good combination. No wonder Costco has engendered loyalty, reflected in the strong membership retention rates. This includes 91% renewal rates in the U.S. and Canada, and 88% worldwide in its fiscal third quarter (ended May 10, 2020).

At a time when other retailers are struggling to deal with online competition, Costco keeps posting solid results. Over the last several years, it has had positive same-store sales (comps) after excluding gasoline sales and foreign exchange translations. Since fiscal 2015, operating income has gone from $3.6 billion to $4.7 billion.

How did Costco fare this year, particularly during the pandemic? Management reduced store hours, put limits on the number of customers allowed in the warehouse at one time, and increased employees' wages.

Despite these steps, its third-quarter comps rose 5% with people spending more, while traffic was weaker due to the company's restrictions. Showing the benefit of a broad merchandise selection, members shifted their purchases from gasoline and pharmaceuticals to the food/sundries (e.g., packaged foods, snacks, and cleaning supplies) and fresh foods categories.

Costco does have its own website, of course. It currently doesn't account for much of the company's sales -- only 4% in fiscal 2019. But the company is beefing this up, and e-commerce sales have been growing rapidly. This includes a two-day delivery offering for non-perishable food and household supplies, and limited same-day delivery for fresh food.

Naturally, with people increasing online ordering during the pandemic, this grew, representing 8% of its third-quarter sales. Its e-commerce sales had a 66.1% comps increase in the quarter, excluding foreign currency changes.

Despite higher selling, general, and administrative expenses due to COVID-19, operating income rose 5% year over year to $1.2 billion.

How secure is the dividend?

With steady profit growth, Costco has consistently increased its dividends annually. Most recently, the board of directors raised the quarterly rate from $0.65 to $0.70, starting with the May payout.

Obviously, this is a positive sign, particularly when many companies have suspended their dividends. Costco generates a prodigious amount of operating cash flow (OCF), easily supporting its dividends. For the first nine months of fiscal 2020, its OCF was $4.6 billion. After deducting $2 billion for capital expenditures, its $2.6 billion in free cash flow handily covered its $860 million dividend payment. Costco's payout ratio is 32%.

Costco's 0.9% dividend yield is certainly not the highest out there. But the company is still growing sales and raising the payout. Additionally, the company has a history of paying special dividends. These were $7 in 2012, $5 in 2015, and $7 in 2017. While no one knows when or if Costco will pay another one, it is good to know that the company has not been shy about sharing the wealth with its shareholders.

With a strong and established business that consistently grows profitability and generates a lot of cash flow, the current dividend looks secure. However, unlike the Costco shopping experience, this high-quality company, with a trailing price-to-earnings ratio of 37 times, is not a bargain. It is worth the price, however.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Lawrence Rothman, CFA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Costco Wholesale and recommends the following options: short January 2022 $1940 calls on Amazon and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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Costco Wholesale Corporation Stock Quote
Costco Wholesale Corporation
COST
$552.99 (1.33%) $7.24
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Amazon.com, Inc.
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